Some rough calculation on Berkshire’s intrinsic value based on 3Q08 results & recent acquisitions
All the cash & cash equivalents = $27,899 M (Insurance & Others) + $531 M (Utilities & Energy) + $4,939 M (Finance & Financial Products) = $33,396 M
Minus of recent acquisition, say $12,500 M = $33,396 M - $12,500 M = $20,896 M = $13,488 per A share
All fixed maturities securities = $29,584 = $23,667 M (assuming default rate of 20%) = $15,277 per A share
Equities securities = $76,042 M = $45,625 M (assuming 40% drop in equities value) = $29,450 per A share
Estimated annualised net profit = $1,057 M x 4 (assuming flat earnings for the next 3 quarters) = $4,228 M = $2,729 per A share
Intrinsic value based on (ex cash & investments) 10X multiple = $2,729 M X 10 = $27,290 per A share
All in all, the intrinsic value based on (earnings, cash & investments) = $85,505 per share A share = $2,850 per B share
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Disastrous bet ... or shrewd trade?
The trouble is, world stock indexes, including the S&P 500, have declined sharply since the trade was struck. The past two months have been particularly rough. In its third-quarter earnings release, dated Nov. 7, Berkshire said its loss to date on the trade is $1.87 billion. Surely, that's proof enough that Buffett made a disastrous bet. Right?
Wrong! In fact, Buffett had fully anticipated the possibility of such losses. Describing the trade for the first time in his 2007 letter to shareholders, he wrote: "... our derivative positions will sometimes cause large swings in reported earnings, even though Charlie [Munger] and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings -- even though they could easily amount to $1 billion or more in a quarter."
In truth, the terms of the trade are highly favorable to Berkshire:
1) At inception: Berkshire, the option seller, received the full $4.85 billion in option premiums up front. The use of this cash is now entirely at Buffett's discretion. Given his track record as an investor, that's a very valuable feature.
2) Over the life of the option: The puts are so-called "European" options -- the buyers can't exercise them until they expire. Furthermore, it's unlikely that Berkshire would have to post any margin collateral against mark-to-market losses; thus, although such losses would reduce Berkshire's earnings, they have no economic impact on the company whatsoever.
3) At maturity: These are long-dated puts, with expiration dates falling between 2019 and 2027. This is an immensely favorable situation, in light of the first point and the long-term upward drift in the stock market.
Given the misunderstanding of this options trade in the credit-default-swap market, which sets the price of insuring a company's debt, I now think the greatest economic risk of this options trade is not inherent in the trade itself. Rather, it is that the credit-rating agencies, including Moody's and Standard & Poor's, will also misunderstand the risks of the trade and downgrade Berkshire, in a move that would increase its cost of funding.
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All the cash & cash equivalents = $27,899 M (Insurance & Others) + $531 M (Utilities & Energy) + $4,939 M (Finance & Financial Products) = $33,396 M
Minus of recent acquisition, say $12,500 M = $33,396 M - $12,500 M = $20,896 M = $13,488 per A share
All fixed maturities securities = $29,584 = $23,667 M (assuming default rate of 20%) = $15,277 per A share
Equities securities = $76,042 M = $45,625 M (assuming 40% drop in equities value) = $29,450 per A share
Estimated annualised net profit = $1,057 M x 4 (assuming flat earnings for the next 3 quarters) = $4,228 M = $2,729 per A share
Intrinsic value based on (ex cash & investments) 10X multiple = $2,729 M X 10 = $27,290 per A share
All in all, the intrinsic value based on (earnings, cash & investments) = $85,505 per share A share = $2,850 per B share
+++
Disastrous bet ... or shrewd trade?
The trouble is, world stock indexes, including the S&P 500, have declined sharply since the trade was struck. The past two months have been particularly rough. In its third-quarter earnings release, dated Nov. 7, Berkshire said its loss to date on the trade is $1.87 billion. Surely, that's proof enough that Buffett made a disastrous bet. Right?
Wrong! In fact, Buffett had fully anticipated the possibility of such losses. Describing the trade for the first time in his 2007 letter to shareholders, he wrote: "... our derivative positions will sometimes cause large swings in reported earnings, even though Charlie [Munger] and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings -- even though they could easily amount to $1 billion or more in a quarter."
In truth, the terms of the trade are highly favorable to Berkshire:
1) At inception: Berkshire, the option seller, received the full $4.85 billion in option premiums up front. The use of this cash is now entirely at Buffett's discretion. Given his track record as an investor, that's a very valuable feature.
2) Over the life of the option: The puts are so-called "European" options -- the buyers can't exercise them until they expire. Furthermore, it's unlikely that Berkshire would have to post any margin collateral against mark-to-market losses; thus, although such losses would reduce Berkshire's earnings, they have no economic impact on the company whatsoever.
3) At maturity: These are long-dated puts, with expiration dates falling between 2019 and 2027. This is an immensely favorable situation, in light of the first point and the long-term upward drift in the stock market.
Given the misunderstanding of this options trade in the credit-default-swap market, which sets the price of insuring a company's debt, I now think the greatest economic risk of this options trade is not inherent in the trade itself. Rather, it is that the credit-rating agencies, including Moody's and Standard & Poor's, will also misunderstand the risks of the trade and downgrade Berkshire, in a move that would increase its cost of funding.
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